Factor Investing is an investment approach that involves targeting specific drivers of returns across asset classes. There are two types: macroeconomic and style. Investing in factors can help improve portfolio outcomes, reduce volatility, enhance diversification and even prevent loss in your portfolio.
Macroeconomic factors include the pace of inflation, economic growth, and how factors explain returns across asset classes like stock or bond markets. Style factors help explain returns within those asset classes. For example, value stocks- those that how low prices relative to fundamental indicators, have historically generated returns greater than the broad market.
Investors looking for downward protection in a volatile market environment might add exposure to minimum volatility strategies to reduce risk, while investors who are comfortable accepting increased risk might look to more return-seeking strategies like momentum.
The Five Factors of Factor Investing
Let’s review different factors.
Value: emphasis is placed on securities that are priced at a discount to other similar securities. The assumption is that over time, purchasing securities at lower prices will lead to higher returns.
Size: we focus on shares of small companies with the expectation that they will outperform those of large companies. It is often observed that other investment factors work well alongside this factor.
Volatility: this factor implies that shares associated with lower volatility perform better on a risk-adjusted basis than those with higher volatility.
Momentum: the purchase of securities that have recently recorded an above average performance.
Quality: the focus is on shares of high-quality companies because they tend to outperform those of lesser quality.
Why are Factors Important?
Factors are the foundation of investing, just as nutrients are the foundation of the food we digest. We need carbohydrates and protein to power through the day. Putting together a balanced diet means understanding what nutrients are contained in our food, and choosing the right mix that best supports our body’s needs.
Our managers understand the factors that drive returns in a portfolio, which enables them to choose the right mix of assets and strategies that fit your objectives.
Factor investing is different from smart beta strategies. Smart beta strategies target factors using a rules-based approach with the goal of outperforming the market-cap weighted benchmark. Enhanced strategies, such as factor investing, use factors in more advanced ways. We seek absolute returns or to complement traditional active strategies.
The Common Factors of Factor Investing
Factor investing is based on intensely studied investment factors-characteristic, quantifiable features of an asset that can be cost-effectively targeted in a diversified portfolio. There are six style factors worth discussing in depth: value, size, momentum, volatility, quality and yield.
Factor Investing vs. Stock Picking
Stock Picking involves deliberately concentrating on the most undervalued securities, while a factor approach maintains a broad diversification across securities to reduce security specific risk. Let’s review other major differences.
Factor Strategies: Active or Passive?
Factor investing is a third pillar of investing; it resides somewhere between active and passive. It does not replace market-cap passive investing, nor does it capture the context of active management. Therefore, factor investing could be thought of as a hybrid, demonstrating qualities that resemble both active and passive investing.
Value, size, momentum, volatility, quality and yield have each delivered returns in excess of the broad market over time, but they have historically performed differently at different stages of the economic cycle based on their unique underlying drivers. Combining these factors provides diversification that may produce more consistent results than investing in single factors.
The Difference Between Active and Index-Based Factor Investing
Factor investing can be conducted through actively managed funds or ETFS. Both of which have advantages and disadvantages. Active managers use self-developed factors or multi-factor models that are monitored and enhanced. On the other hand, index-based products adhere to a set of rules and security selection is set once the index has launched.
Factor Investing With Fixed Income
Investment grade, corporate or emerging markets are considered amongst the most basic bond asset classes, but there can be large differences among individual bonds within these categories that can affect your return. Expanding your investment choices to include factors, either singularly or coupled, can help improve your outcome.
Performance of Factor Investing
There are three variables that affect the performance of factor investing: exposure to rewarding factors, diversification, and management expertise. Let’s review and ponder the track record of top factor investing strategies.
Reduced Volatility with Factor Investing
The Low Volatility factors applies to stocks that have been the least volatile in their asset class over time-avoiding sharp ups and downs unlike other stocks. For this reason, this factor has the potential to outperform the broad market over the long-term, preserving the returns it has made.
Diversification with Factor Investing
Multi-factor investing leverages more than one factor to generate diversified returns, while establishing correlated and uncorrelated beta to possibly escape risk and loss. This is the diversification effect.
Factor Investing vs. Smart Beta Strategies
Factor investing looks at characteristics that help investors understand the behavior of an asset. Factor portfolios are generally thought of as a long/short portfolio, where the investor is long equities that have high exposure tot he factor and short equities that have low exposure to the factor. The factor return is the difference between the two. On the other hand, smart beta is typically long only and looks at company fundamentals.
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